June 23, 2015 China: Consumer Staples Equity Research China Beer: The Final Frontier; potential for industry profit pool to expand 3-7x An awakening giant: 3-7x profit pool Who are “ready”, “willing” and “able”? potential RELATED RESEARCH We identify potential combinations among the CRE: Up to Buy on beer pure play; re-rating on higher China is the world’s largest beer market by eight beer companies with China exposure. The growth vs Tsingtao – published April 23, 2015; volume, but beer prices are among the lowest due transaction most likely to redefine the market Tsingtao: Volume drop not priced in; premium brand to years of intense competition. We estimate the landscape would be if ABI were to acquire SAB challenged; down to Sell – published February 12, 2015 ABI: The compound king; reiterate Buy and add to the current beer industry profit pool at just US$1.1bn, globally and also successfully retain a partnership Conviction List – published October 9, 2014 or 15% the size of that in the US, despite more with CR Snow. Their combined market share is KEY CHART: GSe China beer profit pool from US$1bn than double the volumes. Driven by faster 41% and synergies would be significant. Tsingtao in 2014 to US$3bn-7bn by 2019E China Beer North America Beer China Scenario 1 China Scenario 2 premium beer market growth and consolidation, also has M&A options, but with lower synergies. Industry volume (K tons) our scenario analysis shows the profit pool in 70,000 China 2019E Scenario 1: Government approval: Hurdle not barrier US$3.1bn China could reach US$3bn to US$7bn by 2019E. 60,000 China 2019E Scenario 2: Government approval may prove to be the biggest China 2014: US$1.1bn US$6.9bn 50,000 Approaching last orders hurdle. Concerns include anti-competition and 40,000 As one of the last big global beer markets yet to foreign ownership of iconic consumer brands. fully consolidate, China’s beer companies earn 30,000 However, application of the Anti-Monopoly Law US 2014: US$7.5bn operating margins below the global average and has been lenient in the past. SOE reform classifies 20,000 shy of 10%. With the Top 5 players now holding beer as a competitive industry where majority 10,000 c.75% of the market, and buyers with money in - government ownership is not critical. 60,000 80,000 100,000 120,000 140,000 Industry retail their pockets, we are approaching “last orders”. sales (US$mn) Filling the bottle: Key stock calls Source: Goldman Sachs Global Investment Research. We expect M&A to rise given: 1) global and China: Buy CRE, Sell Tsingtao given CR Snow’s i) domestic players are facing challenges growing stronger growth, ii) more attractive valuation, and organically; 2) unlevered balance sheets; 3) iii) a ‘free option’ for earnings upside from industry attractively priced China assets; and 4) recent SOE consolidation. Europe: Buy ABI (CL) on cash reform is more welcoming of strategic deployment/synergies and SAB on high growth investments. exposure. Sell Carlsberg on structural challenges. Lisa Deng +852-2978-0528 [email protected] Goldman Sachs (Asia) L.L.C. Goldman Sachs does and seeks to do business with companies Mitch Collett covered in its research reports. As a result, investors should be aware +44(20)7774-1060 [email protected] Goldman Sachs International that the firm may have a conflict of interest that could affect the Nicole Thain objectivity of this report. Investors should consider this report as only a +44(20)7552-4397 [email protected] Goldman Sachs International single factor in making their investment decision. For Reg AC Keiko Yamaguchi +81(3)6437-9980 [email protected] Goldman Sachs Japan Co., Ltd. certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S. The Goldman Sachs Group, Inc. Global Investment Research June 23, 2015 China: Consumer Staples Table of contents Executive summary: China Beer – approaching last orders 2 Got beer? China’s market offers the highest growth globally over the next five years 8 Stars may be aligning for an industry “big bang” 12 Government approval the biggest hurdle 19 Who are “ready”, “willing” and “able” parties? 21 Transactions that could create the right brew; ABI-SAB-CR Snow, Tsingtao-CR Snow 25 Appendix 1: China’s beer industry – premiumization the key catalyst 28 Appendix 2: A lesson from the US; not everyone is a winner in industry consolidation 32 Disclosure Appendix 34 Prices in this report are as of the June 18, 2015 market close unless indicated otherwise. Executive summary: China Beer – approaching last orders A common frustration with the China beer ‘consolidation story’ is that despite 15 years of ongoing industry consolidation, significant earnings improvement has not yet transpired. However, with the Top 5 companies now holding nearly 75% market share of volumes and external factors aligning, we believe further consolidation could fundamentally redefine the market landscape and competitive position. In this report, we attempt to answer three key questions: 1) Why is it important for investors to pay attention to China’s beer industry? 2) Why now? 3) How & Who – How the events could transpire, and which parties could be involved? Our analysis is not conclusive and we do not intend it to be so. However, we aim to help frame the discussion on the progress of China’s beer industry based on several requisite conditions domestically, and globally. In the end, not all players benefit equally from industry consolidation (as witnessed in the US) and we set out our key stock recommendations based on our fundamental analysis of each player’s competitive position and valuation. Key stock calls – China: CRE (Buy), Tsingtao (Sell); Europe: ABI (CL- Buy), SAB (Buy), Carlsberg (Sell). Goldman Sachs Global Investment Research 2 June 23, 2015 China: Consumer Staples Why: Profit pool to increase from US$1bn in 2014 to US$3bn-7bn by 2019E China is the world’s largest beer market by volume – and is more than double the size of the US market – but its ASP of beer is one of the lowest. For years, intense competition has suppressed prices and built excess capacity, and we estimate the current industry profit pool in China is just US$1.1bn compared to US$7.5bn in the US. With domestic players (CR Snow, Tsingtao and Yanjing) all earning below 10% operating profit margins in 2014, we see a clear upside opportunity towards the 20% plus EBIT margins earned by global peers in more consolidated markets such as the Americas and Africa where the best brewers can earn over 30% EBIT margin. We expect China’s beer retail sales to increase by an 8% CAGR over 2014-2019E to reach US$110bn, driven by our assumptions of an annual 5% price increase and 2.4% volume increase. Based on scenario analysis, we calculate a potential industry profit pool of US$3.1bn-US$6.9bn by 2019E (vs. US$1.1bn currently), driven by premiumization and further market consolidation. Exhibit 1: We forecast China’s beer industry profit pool could move from the current US$1.1bn level to US$3bn-7bn by 2019E Beer industry profit pool in China and the US, 2014E/19E China Beer North America Beer China Scenario 1 China Scenario 2 Industry volume (K tons) 70,000 China 2019E Scenario 1: US$3.1bn 60,000 China 2014: US$1.1bn China 2019E Scenario 2: US$6.9bn 50,000 40,000 30,000 US 2014: US$7.5bn 20,000 10,000 - Industry retail 60,000 80,000 100,000 120,000 140,000 sales (US$mn) Note: Estimate of current industry profit level based on: 1) announced operating profits of major industry players; and 2) an estimated percentage margin for remainder of smaller players in the market. Source: Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 3 June 23, 2015 China: Consumer Staples Why now: The case for an industry “big bang” China beer consolidation has been ongoing for the past 15 years but has failed to redefine market structure as deals have been limited to small-mid-sized players. With the Top 5 beer companies in China now holding c.75% market share, further consolidation among these players could mean a fast and radical change to market structure. Moreover, we view that external conditions are now aligned, including: 1) the return of industry players to acquisitive growth; 2) unlevered balance sheets; 3) asset values in China appear attractively priced; and 4) recent China SOE reform adopts a more welcoming stance towards foreign investment. How & Who: The “ready”, “willing” and “able” parties Using “ready” (industry regulation, company specific hurdles), “willing” (strategic fit) and “able” (financially capable) criteria we identify potential combinations among the eight beer companies that have exposure to China. Our analysis shows that the biggest transactions with regards to market share would be: 1) CR Snow-Tsingtao (43% combined market share, based on 2014 data); or 2) CR Snow-ABI (41%). While a CR Snow-Tsingtao combination could be limited by company specific ownership hurdles, ABI acquiring SAB globally and successfully retaining a partnership with CR Snow would likely be the most transformational to the market landscape. Government policy is likely to be the biggest hurdle to industry consolidation given anti-trust and government ownership concerns although we do not believe that it is unsurmountable. Historical application of Anti-Monopoly Law in China defines a “market influential” position as two players having 66% or more market share.